The Significance of Market Capitalization in Portfolio Management over Time

Abstract

Market capitalization is one of the most important determinants of portfolio returns. For example, in the first eleven months of 1998, the Russell 1000, a large-cap index, advanced by 19.42%, while the Russell 2000, a small-cap index, declined by 8.23%. This recent experience is at odds with the documented superior long-run performance of small-cap stocks. On average, smaller-cap stocks do outperform large-cap stocks, but the performance advantage of small-cap stocks is hardly constant and, in fact, can be reversed in certain investment climates. This variability is in part predictable. Investors who can successfully manage their market capitalization exposure will realize significant rewards over investors who either ignore their exposure or are unable to alter it. The author argues that current tendency to handcuff a manager to a narrow capitalization range may be a mistake. Over time, greater flexibility in shifting market capitalization will enhance returns. Either managers should be given greater flexibility to alter the capitalization exposures, or investors and their consultants should dynamically adjust allocations to different capitalization categories. In either case, the author contends that improving performance in short-run horizons will enhance long-run performance. Far from being dead, market capitalization still matters very much.